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The Unwarranted Power Of ISS In Dan Loeb Vs. Sotheby's

With his riveting campaign against global auction house Sotheby’s on a crescendo, billionaire hedge fund manager Dan Loeb got the support of a heavy-hitter in the proxy-battle arena: Institutional Shareholder Services (ISS). The largest proxy services firm, reputed to be able to mobilize up to 30% of the vote in some cases, ISS agreed with Loeb’s claims on financial underperformance, lack of an online strategy, and fee-splitting, recommending two of Third Point’s three candidates for the board. Sotheby’s, the 270-year-old auction house, acknowledged ISS’ power, focusing on their rejection of one of Loeb’s nominees, while reiterating Loeb has “made no case that change is warranted,” calling his plan “erratic” and his behavior “disruptive” and short-termed.

All of this also brings attention to ISS, which has become increasingly relevant given the rise of activism. ISS is a for-profit advisory services firm that both provides research and consulting, but fails to disclose if a firm is a client, which could clearly lead to a conflict of interest and moral hazard. Some research paint these firms as black boxes, while at the same time they face the scrutiny of the Securities and Exchange Commission which is trying to figure out how to properly regulate them.

ISS’ power is unquestionable. “Both Mr Loeb and Sotheby’s have been courting the endorsement of the ISS,” the FT reported. Only a few hours before the release of ISS’ report granting Dan Loeb’s Third Point a solid victory, Sotheby’s responded by preemptively releasing first quarter financials showing a 40% increase in net auction sales to $730 million based on a 34% increase in impressionist and contemporary sales. In a statement just after the report, Sotheby’s noted “that ISS rejected one of Third Point’s nominees and recommends that shareholders vote for our Say on Pay proposal.” Shares in Sotheby’s surged nearly 5% on Thursday.

Yet the level of leverage the ISS has may be unwarranted, as trust in the firm’s procedures could be misplaced. According to research by Stanford Business School’s David Larcker, who heads a center focused on corporate governance, proxy advisory firms like ISS and rival Glass Lewis are opaque institutions that rely on limited data to make decisions that could result in billion dollars moves.

Larcker, along with researchers Allan McCall and Brian Tayan, question the limited number of participants in ISS’ surveys, from which they derive their general opinions on corporate governance and base their recommendations. ISS doesn’t adequately disclose the types of respondents, and their survey is flawed, the academics argue. Ultimately, they call into question whether the ISS is enhancing shareholder value, raising red flags as to how much sway these firms should really have.

Another issue raised about proxy advisory firms is their power, and their underlying intentions. Concerned, the SEC called for a debate on the issue, where prominent corporate lawyer Trevor Norwitz put it like this; “The question really is whether I.S.S., which owns no stock, should have the power of a $4 trillion voter.” Another participant compared the proxy advisory firms with credit rating agencies before the financial crisis, where Standard & Poor’s, Moody’s, and Fitch most definitely contributed to the worst financial collapse since the Great Depression. ISS president Gary Retelny responded by claiming “we have very strong Chinese Walls.”

While there is a benefit to having proxy advisory firms, namely that they can provide useful information to smaller pensions funds and institutional investors regarding proxy fights, it is unclear whether the current model adequately addresses moral hazard. Regardless, both Dan Loeb and Sotheby’s seem to care about what they have to say.

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